What’s the Deal With Oil Prices?

Driving past gas stations these days is like driving through a mini-time warp as those sub-$2.00 per gallon gas prices bring me back to nostalgic days of the early 2000’s when I had free time and hair.

Despite the feel-good nature of the lower gas prices, I think we should all take a step back and consider the historical perspective, some reasons for the price fluctuations and what it means to our everyday financial situation.

First, some perspective: according to gasbuddy.com the national average for a gallon of gasoline was $2.23 on New Year’s Day 2015.  That’s pretty cheap when compared to recent years but not so cheap when we factor in the longer term trend and back out the impact from inflation.  In nominal terms (another way of saying “including inflation”) a gallon of gas hasn’t been this cheap since the economy collapsed during the financial crises in late 2008.  But in “real” terms (a fancy way of saying “backing out inflation”) gas has actually been pretty cheap from about 1985 to about 2004 when the average price was below $2.50 and for most of that time, was below $2.00 a gallon.  So while it may feel “cheap” now, we’ve seen much better “real” impact on our pocketbooks with much lower prices in the go-go days of the 1980’s and 1990s.

So what’s the reason for the change in price over the last few decades?  Well, as in most cases where there’s not an enormous amount of “unnatural” impacts on prices (like monopolies or government intervention) gas prices roughly track oil prices and oil is a commodity traded in the global marketplace.  While there are some “unnatural” forces like trade agreements and a de-facto oil cartel in OPEC, the biggest impact on prices is still likely our old friends from Economics 101 – supply and demand.  As China and other “emerging markets” came on line in the 1980’s and 1990’s I think it’s fair to say their industrial demand drove the price higher.  Conversely, we’ve seen a few things driving the price down the last few months.  These downward forces include:

  • A slowing global economy outside the US, especially in Europe, China and other “emerging markets”
  • An influx of supply from the US with the massive expansion of oil extraction due to technological advances in fracking
  • The decision by OPEC not to decrease production but instead, keep pumping oil at the same pace

This last one may need some additional detail.  In my opinion, I wouldn’t be surprised if the OPEC nations in the Middle East have had just about enough of the expanded oil drilling in the US and Canada and are willing to endure a long period of lower prices in order to “starve off” further expansion of these drillers.  It’s as if OPEC knows they have the balance sheet to take losses but are betting that the smaller, faster growing players in North America don’t have a large financial cushion.  With much lower prices, the smaller players here will rapidly see their profitability and funding capital dry up (pardon the pun).  Once all the weak players are eliminated, they will happily return to their price-fixing days and adjust production with demand in order to achieve a more profitable price for their product in the coming years.

So factoring all this in:  what does it really mean to our portfolios and our financial situation?  In short, I think it could be a good-news / bad-news scenario and here’s why:

Quite obviously, the good news is that in the foreseeable future, most of us will be getting a break on the monthly cost for fuel.  How much?  I’ve read one estimate where the average American should save about $600 per year.  Of course the savings will be specific to how much fuel you use but in most cases, I wouldn’t say it’s a life-changing windfall.  From an economic standpoint, I’ve read estimates where the US could realize 0.5% boost to GDP which could help some companies’ profitability due to better demand, which theoretically could help stock prices.

The bad news is that there are some investments that might be negatively impacted.  These includes bonds for some “emerging market” countries heavily dependent on oil as a big export.  Some are small but some are quite large (think Russia & Venezuela).  In the “reach for yield” due to low interest rates for the last 6 years, these bonds and / or bond funds could sell off in short order.  In addition, US companies in the oil business could also see further declines on top off the damage incurred in late 2014.  In many peoples’ portfolios, these have been relied upon as bond substitutes as they usually pay ample and consistent dividends.  Finally, stock prices overall could be impacted by geopolitical implications of lower oil prices if an oil-dependent country like Russia gets desperate and sees the need to stir up some military action in order to redirect its citizens’ attention away from what will likely be a recessionary economy in 2015.  Military action breeds uncertainty and financial markets do not like uncertainty.

So what are we to do?  I’m going to sound like a broken record here but the strategy is the same:  control what you can control.  Specifically, that starts with having a diversified portfolio across asset classes and geographies because no one really knows how this oil price decline will yield winners and losers.  There are just too many moving parts and uncertainties.  From a budgeting perspective, maybe save that little extra in your bank accounts and add a little to your investment accounts (taxable or tax deferred depending on eligibility) or maybe add a little extra to the kids’ college funds.

Most importantly, don’t overact to the fluctuations of some assets in your portfolio. Use the volatility as a means to rebalance and maintain your long term investment strategy and allocation.

Who knows? A year from now gasoline prices could be higher than they were just 6 months ago- it’s just impossible to know for sure.  Instead, of worrying about things we can’t control, focus on sticking to the savings and investment plan and put on some Hall n’ Oates as you drive by the gas station and reminisce about those days of $1.89 gasoline.

 

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